Everyone with an interest in business remembers learning about how prices are determined in a free market economy based upon supply and demand. In economics courses, professors give an equation or a graph that shows the supply and demand and we (students) have to determine where the two intersect. This has been a useful thing to learn, but has left a big question in my mind – how does a real business determine how much consumers , system, in which they try different prices to discover which result in the highest profits. I am especially curious to know how businesses determine prices for new products or services, without the benefit of existing financial models or data.
As a student with a lot of classroom experience but little exposure to the corporate world, I hope that those of you with real business experience can tell me what you know about how pricing is done.
I can tell you from my experience competition will help you set your pricing. If a customer feels he can get your product or service for x amount of money from a competitor you will be hard pressed to get much more than that. There are several factors that can change that scenario. Service above and beyond the competition is something people will pay more for. If you are innovative and have something no one else can offer you can see what the market will bear. Just keep in mind if you start doing well someone will try to copy you and may influence future pricing. Being an upstart company also affects pricing. Do you want to make a great profit on a couple of customers or do you want to try to get market share with a lower price? I feel the best thing for a new company is to offer a bargain to a lot of customers get them to see the value in your service or product and then raise your price to a level the majority of your customers will pay. The bottom line is you can take any formula you want but if the market place will not pay it you will throw the formula away and seek a fair market price.
I think that is well said by Airman. Supply and demand curves work in established industries but a start-up product/service has no established curves for the specific market you are targeting.
I think about it two ways:
(i) What is your closest competitor (competing technology, service, etc.) charging and therefore what can the cusatomer afford to pay, i.e. what dollars am I trying to get from my customers (what % of their budget) and where else could they spend that money. That pricing point and the cost vs. benefit analysis they will do to make their decision is vital information you need to be thinking about when deciding what the market will bear price wise.
(ii) In the long-run, a business is only worth something if the returns to the equity investors are adequate for the risk being taken. Therefore, you have to generate a certain margin or free cash flow to generate the required returns. When you forecast out the cost of your product and then apply an adequate margin, you will have your long-run price that is required to make the business viable. There can be a lot of pricing strategies etc. in the short-run (to drive market share etc.) but you have found your price floor.